Why did the CBT reduce policy rate given the scope of uncertainties, the rise in the current account deficit?

In the first phase of the implementation of the new policy framework, officials of the Central Bank of Turkey (CBT) referred to two important figures. First shows the "policy rate for financial stability" and "policy rate for price stability" for different output gaps. This figure makes us think that the CBT believes that in the case of rapid improvement in the production level, interest rate required for financial stability will be higher than that required for price stability. This is the aimed scenario: high growth rate, level of production above or rapidly approaching the potential rate of production. The CBT states that an interest rate consistent with the inflation target will fall short to ensure financial stability given the high growth rate. 

Two options ahead
Under these circumstances, there are two options ahead: First is to increase the policy rate to maintain financial stability. The CBT is of the opinion that this option will increase short term foreign exchange (FX) inflows which is one of the main problems facing Turkey and will further the depreciation of the lira and deterioration of the current account balance. Second option is to increase the reserve requirements.

The second graph has four zones. First two are accelerating inflation versus slow and rapid credit expansion and the others are decelerating inflation versus slow and rapid expansion. The CBT decides how to employ the two main monetary policy tools depending on the position of the economy within these zones. Take the two zones with rapid credit expansion. The CBT maintains that in that case the reserve requirements shall be increased. Policy rates are increased (decreased) if credit expansion is accompanied with accelerating (decelerating) inflation. 

Why the rate was cut?
The challenge facing monetary policy goes as follows: in the recent period, the CBT increased the reserve requirements and cut the policy rate twice, simultaneously. The latest cut was introduced in January 20. What was the rationale of the CBT's action in the light of the above information? It is quite obvious. To begin with, credit expansion was rapider than desired. Second, inflation was slowing down. The CBT report published in the end of January revealed that the expected inflation for the end of 2011 was consistent with the inflation target. The mid-point of the estimation interval was 5.9 percent and the target is 5.5 percent. But the report published three months later in April 28 revised the midpoint upwards to 6.9 percent. The realized inflation in May was as pessimistic as this estimation: 7.2 percent.

Then, there should be the questions to ask: Why did the CBT reduce policy rate given the scope of uncertainties, the rise in the current account deficit and the fact that fiscal policy was loosened compared to the year before? Given the fact that the CBT reports do not criticize sufficiently the loosening of the fiscal policy and that other relevant institutions do not take harmonious action with the CBT to slowdown the credit expansion, what reaction will the Bank take against the recent rise in inflation and the deterioration in inflation estimates in the last three months? Will the Bank once again increase the reserve requirements and try to ensure the diversion between the policy rate and market rate to increase the uncertainty perceived by banks, risking the reliability of the former? Or will it increase the policy rate cut at the end of January? The bank might, referring to the headline inflation that is still consistent with the inflation target despite demonstrating an upwards movement, not increase the policy rate and also keep the reserve requirements unchanged indicating that the pace of credit expansion slows down when some daily moving average is considered. Who knows?

After all, the CBT was addressing only about monetary contraction to ensure the flexibility of the monetary policy in the face of current uncertainties and trying to maintain a certain degree of ambiguity. Maybe we can be contended with the policy rate cut introduced in January in spite of all the ambiguity and the adverse outlook of the fiscal policy.

This commentary was published in Radikal daily on 07.06.2011